You own an unused gold mine that will cost $100,000 to reopen. If you

QUESTION

You own an unused gold mine that will cost $100,000 to reopen. If you open the mine, you expect to be able to extract 1,000 ounces of gold a year for each of three years. After that, the deposit will be exhausted. The gold price is currently $500 an ounce, and each year the price is equally likely to rise or fall by $50 from its level at the start of the year. The extraction cost is $460 an ounce and the discount rate is 10 percent.a. Should you open the mine now or delay one year in the hope of a rise in the gold price?b. What difference would it make to your decision if you could costlessly (but irreversibly) shut down the mine at any stage?
1.The following assumptions have been made: i) the initial cost of investment at $100,000or extraction cost per ounce at $460is not expected to change. 2. First year price=$500*1000=500,000 Extraction Price=$460*1000=460,000 Difference is $40,000 The price per ounce would be $40,000 and if other things remain same you should not open the firm immediately. Let us assume that the mine is opened, after a one-year wait, with a starting price of $5,500. ii) For this alternative, the mine has to be abandoned at t-3, if the price reaches $4,500. iii) The rationale is that there is likely to be a loss of $1,00,000, and the probability of this occurring is 0.125. The expected value is presented in Table¦

11. Evaluation of Strategy 2: i) Without an option to abandon, the expected value for this alternative is $5,62,454 (Table 6) ii) The NPV with an option to abandon is $5,62,454 + 8,536, that is, $5,70,990 Conclusion: i) value of option to abandon the mine is $1,07,085; ii) Value of option to abandon the mind under strategy 2 is $5,70,990; and iii) Strategy 2 is optimal, and provides a better value, that is, wait for one year, open the mine if the price is $5,500.

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